Why does technical analysis work on indices?

[techst]

I know that sounds like an odd question but let me explain.

As I understand it, technical analysis is basically a self fulfilling prophesy.

Forgive me if I am wrong, but many many traders look at the same charts and see Support and Resistance levels, trend lines waiting to be broken, double tops, double bottoms, fibonacci levels, special cycles, patterns, moving averages, divergences etc and they all use those same levels (Admitedly in many different ways) to decide their entry and exit points.

So therefore price will bounce off a trend line or fibo level, broken support will become resistance etc simply because there are so many traders looking for those levels, they make it happen. I can't think of a better explanation for why Technical analysis works on Forex, shares etc.

If the above is a true explanatoin for why TA works then what has me puzzled is why it works on indices.

For example the value of the FTSE 100 is simply a sum or some such calculation of the value of the top 100 shares at any given moment. Now I can understand why technical analysis. would work for each of those shares individually for the reasons above, but in that case wouldn't the value of the index itself be chaotic - as it is made up of the TA applied to so many different shares, all of which behave in different ways at any given moment?

I hope I explained the question well enough to make sense.

Any thoughts anyone?

Rich

For what its worth Richy, I think this is a really interesting question. How can the FTSE have support a level X if level X made up of 100 different stocks? Are we giving to much respect to technical analysis with regards to indices?

I really do not pay to much attention to exact levels on indices, I like to know if its going up or down or sideways I then trade individual stocks in that direction.

good on yah for posing this question :clap:

 

[russell444]

technical analysis does not work for index trading

You say: FTSE reflects what is happening to the FTSE futures which are directly tradeable and therefore subject to the trader activity that causes TA to "work.
This is not correct. the FTSE does not reflect FTSE futures at all. The FTSE reflects the average of all the share price shanges of all the companies in the index. Thus, any kind of technical analysis for index trading is worse than useless.

 

[FXX]

It's actually a little more complicated than an average. It's comprised of prices, shares, free float, a divisor, etc... The selection process is weighted by market cap

Its actually one of the simpler index formulas out there



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[mpups]

You say: FTSE reflects what is happening to the FTSE futures which are directly tradeable and therefore subject to the trader activity that causes TA to "work.
This is not correct. the FTSE does not reflect FTSE futures at all. The FTSE reflects the average of all the share price shanges of all the companies in the index. Thus, any kind of technical analysis for index trading is worse than useless.

Wow.. talk about blind leading the blind

but to be fair, barjon was wrong in what he said:

FTSE reflects what is happening to the FTSE futures which are directly tradeable and therefore subject to the trader activity that causes TA to "work" if it ever does..

 

[barjon]

Wow.. talk about blind leading the blind

but to be fair, barjon was wrong in what he said:

In what bit? That FTSE reflects what is happening to the FTSE futures? The vexed question of whether TA “works”. Or the way I happen to use it?

 

[mpups]

In what bit? That FTSE reflects what is happening to the FTSE futures? The vexed question of whether TA “works”. Or the way I happen to use it?

hello

Just the bit about the calculation. Its based on a formula, as fxx mentioned, not the futures contract. Unless you were referring to an OTC price after hrs.

 

[barjon]

hello

Just the bit about the calculation. Its based on a formula, as fxx mentioned, not the futures contract. Unless you were referring to an OTC price after hrs.

Yes, absolutely. That’s why I said that ftse REFLECTS what is happening on the futures, not that it is calculated from the futures. If you prefer, what happens with the futures influences the price of a basket of shares to the degree that the onward calculation of ftse moves it by a similar degree to the futures. The futures and the index keep pretty much in step. Similarly, the other way round, what happening with shares (and hence ftse) can influence what happens with the futures.

 

[mpups]

Yes, absolutely. That’s why I said that ftse REFLECTS what is happening on the futures, not that it is calculated from the futures. If you prefer, what happens with the futures influences the price of a basket of shares to the degree that the onward calculation of ftse moves it by a similar degree to the futures. The futures and the index keep pretty much in step. Similarly, the other way round, what happening with shares (and hence ftse) can influence what happens with the futures.

I did notice that you said reflects. In the context of the thread question though any reverse influence from the futures contract would be mostly irrelevant. The index is calculated from the underlying stocks.

 

[FXX]

Yes, absolutely. That’s why I said that ftse REFLECTS what is happening on the futures, not that it is calculated from the futures. If you prefer, what happens with the futures influences the price of a basket of shares to the degree that the onward calculation of ftse moves it by a similar degree to the futures. The futures and the index keep pretty much in step. Similarly, the other way round, what happening with shares (and hence ftse) can influence what happens with the futures.

It doesn't reflect what's happening on the futures. Its calculated off a formula and that formula has zero parameters that's derived from the futures market (i work at an an index provider and very familiar with the process). The futures market reflects the a market of hedging risk on the underlying. There is zero influence the futures market has on the underlying index because the formula is based on the composition data and not a future value component.

Go look at ftse calculation pdf if you don't believe me.

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[mike.]

Good post fxx, Ive often wondered why the indexes have such a positive correlation, Could you explain the above in a little more detail or by means of an example ?

 

[russell444]

Yes, I absolutely agree that the futures market has no influence at all on the FTSE index price and how it moves. The FTSE in no way 'reflects' what is happening in the futures market. The FTSE price is entirely based on the prices of the stocks listed in the index. Hence, any kind of technical analysis is totally irrelevant and useless when it comes to predicting how the FTSE will move. When you see anybody applying technical indicators to an INDEX (e.g. support, resistance, head & shoulders, etc.) you know they are in cloud cukoo land.

 

[FXX]

Good post fxx, Ive often wondered why the indexes have such a positive correlation, Could you explain the above in a little more detail or by means of an example ?

An example taken from the web

Note :Notional value = price of futures contract x contract multiplier.

assume the E-mini S&P 500 futures are priced at $2185.00, which results in a notional value of $109,250. Now consider a portfolio manager with a $10 million S&P 500 equity risk position. Suppose she wants to reduce her exposure to the S&P 500 index by 10%. She could utilize E-mini S&P 500 futures by selling futures in a ratio based on the notional value of the futures contract.

Hedge ratio = value at risk ÷ notional value of futures contract

In this case, 10% of $10 million is $1 million that needs to be hedged. To calculate the equivalent futures contracts needed to hedge this position, divide $1 million by the notional value of the futures contract, which is $109,250. This equals 9.15, or the equivalent of nine E-mini S&P 500 futures contracts.
Say the S&P 500 index goes down by 3%, from 2185.00 to 2119.50, a drop of 65.5 index points. The portfolio loses 3% or $300,000. If the manager sold nine futures contracts, she would have gained $29,475. This is derived as follows: 2185.00 – 2119.50 = 65.50 index points: 65.50 index points x $50 per point x 9 contracts = $29,475.
The portfolio manager’s net result is $300,000 minus $29,475 = $270,525 or a 2.7% loss rather than 3.0%. She has effectively reduced her losses by 10% adding value to her shareholders.


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[barjon]

It doesn't reflect what's happening on the futures. Its calculated off a formula and that formula has zero parameters that's derived from the futures market (i work at an an index provider and very familiar with the process). The futures market reflects the a market of hedging risk on the underlying. There is zero influence the futures market has on the underlying index because the formula is based on the composition data and not a future value component.

Go look at ftse calculation pdf if you don't believe me.

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I know. All I am saying is that the share prices themselves are influenced by what’s happening on the futures (and, of course, vice versa). That change in the share price then causes a change in the index value.
Why don’t you guys read what I said rather than dispute something I didn’t say. I KNOW HOW THE INDEX IS CALCULATED THANK YOU.

 

[FXX]

I know. All I am saying is that the share prices themselves are influenced by what’s happening on the futures (and, of course, vice versa). That change in the share price then causes a change in the index value.
Why don’t you guys read what I said rather than dispute something I didn’t say. I KNOW HOW THE INDEX IS CALCULATED THANK YOU.

Sorry barjon, I mean no offence. I don't agree that the futures influences share price. It is in fact the other way around. The price of an individual stock is influenced by the company results, takeover bids, new product launches, regulatory, company performance, geopolitical events, and economic conditions. It can't possibly be influenced by a futures market because the futures market is underpinned by the underlying.





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[barjon]

Sorry barjon, I mean no offence. I don't agree that the futures influences share price. It is in fact the other way around. The price of an individual stock is influenced by the company results, takeover bids, new product launches, regulatory, company performance, geopolitical events, and economic conditions. It can't possibly be influenced by a futures market because the futures market is underpinned by the underlying.





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Well, you’ve a lot to learn then (joke, in case you think otherwise). Search back on here and you’ll find plenty of good debate on what is leading what. It goes both ways.

If you think futures are lagging and follow what the shares do (index does) then just watch the instantaneous response on futures as traders hit the button on important news releases.

 

[FXX]

Well, you’ve a lot to learn then [emoji38] (joke, in case you think otherwise). Search back on here and you’ll find plenty of good debate on what is leading what. It goes both ways.

If you think futures are lagging and follow what the shares do (index does) then just watch the instantaneous response on futures as traders hit the button on important news releases.

I don't need to learn from a forum. I get my information from working at investment banks, hedge funds, and exchanges. My job is to work with sensitive trade data meaning I work close to trading desks. A forum has zero merit by my books.



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[FXX]

just watch the instantaneous response on futures as traders hit the button on important news releases.

I trade the news in case you are not aware of this so know very well how it affects the market. You don't seem to understand the purpose of the futures market. If a news release happens, do you think it drives the futures market first and then the stock market?



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[barjon]

I trade the news in case you are not aware of this so know very well how it affects the market. You don't seem to understand the purpose of the futures market. If a news release happens, do you think it drives the futures market first and then the stock market?



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No I think traders are making their assessments on whether the news is going to be good or bad for the market and trading accordingly (with a bit of bluff thrown into the mix).

As an aside I respect your position that all is down to the shares in the end and that fundamentals rule ultimately. That doesn’t necessarily help day to day trading though.

Towards the end of the tech bubble, for example, many a wise head was pointing out that the tech shares were grossly overvalued. They were ultimately proved right but they would have lost a lot of money continually shorting before the bubble finally burst. Those TA trend followers, though, did very nicely.

 

[mpups]

Yes, I absolutely agree that the futures market has no influence at all on the FTSE index price and how it moves. The FTSE in no way 'reflects' what is happening in the futures market. The FTSE price is entirely based on the prices of the stocks listed in the index. Hence, any kind of technical analysis is totally irrelevant and useless when it comes to predicting how the FTSE will move. When you see anybody applying technical indicators to an INDEX (e.g. support, resistance, head & shoulders, etc.) you know they are in cloud cukoo land.

That's right because on Earth the technical analysis fairies only have enough power to move individual stocks, only in cloud cuckoo land is their magic strong enough to move the whole index

 

[tomorton]

Yes, I absolutely agree that the futures market has no influence at all on the FTSE index price and how it moves. The FTSE in no way 'reflects' what is happening in the futures market. The FTSE price is entirely based on the prices of the stocks listed in the index. Hence, any kind of technical analysis is totally irrelevant and useless when it comes to predicting how the FTSE will move. When you see anybody applying technical indicators to an INDEX (e.g. support, resistance, head & shoulders, etc.) you know they are in cloud cukoo land.

Very funny. Really funny.